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Turkey likely to unveil new economic model as cost of servicing debt surges

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Turkey likely to unveil new economic model as cost of servicing debt surges

Turkey's finance ministry is set to unveil a new economic model, according to an Aug. 9 Financial Times report, sparking hopes from exasperated investors that the government and central bank will take long-awaited measures to tackle rising inflation and currency depreciation.

Minister for Treasury and Finance Berat Albayrak plans to maintain the country's budget deficit at below 2% of GDP, with economic growth of between 3% and 4% expected in 2019, a decline on its previous forecast of 5.5% and sharp decrease on the 7.4% achieved in 2017.

But investors place more emphasis on action by the central bank of Turkey, hoping it will take extraordinary measures to increase interest rates as was undertaken May 23 when raised rates were hiked by 300 basis points.

The cost of Turkish debt has surged subsequently. Yields on two-year bonds were up to 21.4% as of 7:55 a.m. ET on Aug. 9, and the cost of insuring the debt with credit default swaps also jumped. Turkish five-year CDS reached 369 basis points the same day, the highest level since March 2009.

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The calculated probability of a Turkish default is now above 20%, more than double the likelihood at the beginning of the year. Adding to the economic woes has been the U.S.' decision to impose sanctions on Turkish Minister of Justice Abdulhamit Gül and Interior Minister Süleyman Soylu in retaliation for the October 2016 arrest and continued detention of Andrew Brunson, a U.S. pastor who stands accused of espionage and aiding terrorists. The latest talks between the two countries to enable Brunson's release appear to have stalled.

Market observers expect inflation to reach 20% after the headline CPI rose to 15.9% in July, well above the 3%-to-7% target range. The central bank's lack of action to tackle inflation with higher interest rates appeared to confirm market fears that the bank is not acting independently of President Recep Tayyip Erdogan, who previously described interest rates as the "mother of all evil."

"Good to see Minister Albayrak aiming to cut the deficit sub-2% and rollover ratio for domestic debt below 100% but the market needs to see specific details as to how they will do this," said Timothy Ash, an emerging markets economist at BlueBay Asset Management. "Credibility is rock bottom given [the central bank's] actions to date."

The widening CDS spreads show the willingness of investors to continue to roll over Turkey’s short-term debt "is diminishing," according to ABN AMRO emerging market economist Nora Neuteboom.

Meanwhile, the central bank stepped in Aug. 6 to lower the amount of reserves lenders are required to hold in an effort to halt the slide in the currency, but investors interpreted the move as another missed opportunity for more definitive measures.

Turkey has also been spending its foreign-currency reserves. The central bank's official reserves for dollars and gold combined fell 8.3% in June to $98.4 billion, reducing the potential to support its currency.

Some question whether Turkey is doing too little too late. "The time for interest rate hikes alone as a mechanism for stabilizing the economy looks to have passed," wrote Salman Ahmed and Jamie Salt of investment management group Lombard Odier in a research note.

They say external support from the International Monetary Fund could now be necessary, which would likely require Turkey to rein in its expenditure plans and adopt more orthodox policy than President Erdogan has proposed. "The prospect of capital controls now begins to seem a real possibility."

Against this backdrop, domestic banks are increasingly under pressure. The price of state-owned lender Türkiye Halk Bankasi AS' 5% bonds due 2021 have fallen roughly 10 basis points during the first week of August to an all-time low of 74 cents on the dollar. That equated to a spread over the government bond benchmark of 1,370 basis points, putting the bond in distressed territory. They had been trading in the 90s until early June.

In the first quarter of the year, Turkey’s biggest banks recorded a sharp rise in nonperforming loans with rating agency Moody's noting a worsening outlook, expecting bad loans of "well above 4% over the next 12-18 months from a low 2.9% in May." The exposure to foreign investors makes Turkey an outlier among emerging market economies and particularly vulnerable to a weakened currency.